The Role of Institutions in Determining the Cyclical Behavior of Fiscal Policy

The literature argues that while developed economies conduct countercyclical fiscal policy, developing countries often revert to procyclical fiscal policies. This, in turn, tends to further destabilise their economies during periods of crisis. This phenomenon is often attributed to fiscal institutions being weaker in less-developed countries. In this paper, we examine the relationship between institutional factors and the conduct of fiscal policy over the business cycle using a worldwide sample of 182 countries over the period 1995–2015. Contrary to most studies, we found robust statistical evidence that anticyclical fiscal policies are run not only by countries with strong institutions but also by those with a weak institutional background. However, the magnitude of the response of fiscal policy to the output gap differs between countries, being much stronger for advanced countries and less pronounced for the developing ones.